Derivatives Known and Unknowns plus Regulators

derivatives market is like a rigged poker game. They picture a smoke-filled room, in which unsuspecting clients are mastered by skilful opponents at investment banks known, perhaps appropriately, as dealers. Now regulators are trying to move more of the game into the open, by shifting OTC derivatives trades onto exchanges or electronic platforms by the end of this year, a target agreed on by G20 leaders in 2009.The dead line is unlikely tobe met considering the present scenarios of jurisdictions.

The America’s Dodd-Frank act requires most OTC derivatives to be traded on a so-called Swap Execution Facility (SEF), which is defined as “a trading system or platform in which multiple participants have the ability to execute or trade swaps”. Recent drafts of the European Union’s Mifid 2 legislation would see liquid OTC derivatives move onto a similar platform dubbed—abbreviation-haters, beware—an Organised Trading Facility (OTF).

These entities will play a similar role to exchanges in equities and futures markets, connecting buyers and sellers of derivatives. At the moment transactions are typically negotiated privately between dealers and clients, such as companies and asset managers. Although highly customised trades or those executed with certain end-users will continue to operate in this way, standardised trades will be legally required to be executed on an SEF or OTF, in full glare of other market players.

That requirement creates an opportunity for new entrants. Setting up as an SEF entails a hefty investment in systems to connect banks and their clients, as well as clearing-houses, where all trades conducted on an SEF will ultimately end up. Despite these costs, a host of different firms has expressed an interest in running them. They include existing trading platforms such as Bloomberg, new entrants including Javelin Capital Markets, and interdealer brokerages such as ICAP.

Putative SEFs are currently working to win the support of dealers and their clients. “You can have the fastest, most reliable platform on earth,” says Charley Cooper of State Street, which is planning to launch an SEF called SwapEx. “But if people aren’t actually showing up to make and take prices, you’ve got a problem.”

Firms that are more established in the world of OTC derivatives have a lot to lose. Interdealer brokerages currently broker anonymous trades between dealers, typically over the phone. Although these firms plan on registering as SEFs, America’s Commodity Futures Trading Commission (CFTC) is proposing rules that prevent trades from being executed this way.

Major investment banks will be placed in a tricky position, too. In a market where trades are conducted over electronic platforms, relationships built up over time with clients could play second fiddle to price. The introduction of central clearing also makes the creditworthiness of counterparties less significant. Over the past decade, these banks have spent colossal sums developing trading platforms with a single bank at its heart. Although the rules governing SEFs are not finalised, such platforms are unlikely to qualify as SEFs, which must send out quote requests to a minimum of five market participants.

Regulators believe OTFs and SEFs will transform the derivatives market, making it more transparent, boosting liquidity and reducing the tasty margins dealers usually earn on trades. Critics argue that there is nothing to stop firms from trading electronically at the moment, or from requesting quotes from multiple dealers. Transparency can be enforced by other means, they say, from mandatory reporting to the use of data repositories that record details of trades. If the market fragments and liquidity is spread across multiple venues, the costs would be high.

Ironically, if fragmentation does occur, dealers see another role for themselves—this time, as aggregators of liquidity from multiple trading venues. Such a move would allow them to preserve their role as gatekeepers to the market. The dealers are not ready to fold just yet.